Michael Lewis has a new book out. It may be more influential than even his 1989 runaway bestseller Liar’s Poker. Called Flash Boys: A Wall Street Revolt, it is an illuminating expose of the shadowy world of high-frequency trading.
For almost a decade, the U.S. equity markets have been corrupted. Established exchanges have fragmented into 13 public exchanges and about 45 dark pools. These are invaded by high-frequency traders spending millions for high-speed connections, co-location and special access. With rapid fire transactions playing out over milliseconds, high-frequency traders stick average investors with stale prices, front-run them or otherwise pick them off. It all happens so rapidly, and with so little transparency, victims are oblivious. No one is immune. Retail investors have had their orders routed in bulk to high-frequency trading firms, earning kickbacks for brokers like Charles Schwab and TD Ameritrade. Dark pools of liquidity—supposedly established to protect institutional investors—earn income selling privileged access to high-frequency traders.
Gleaning reliable information has been difficult. Culpable parties guard their secrets, and the SEC has sat quietly by as hundreds of its employees have accepted high-paying jobs at—you guessed it—the culpable parties. Victims and a few academics have drawn reasonable inferences about what is happening, but independently verifying these can be difficult. Media stories—especially around the time of the 2010 “flash crash”—mostly raise questions. Misinformation distributed by high-frequency traders and their enablers have further obfuscated the situation. What is especially frightening is the sheer magnitude of these activities. Today, half of all trades, and 99% of all orders, are made by high-frequency traders.
Liar’s Poker brought us memorable characters like John Gutfreund, John Merriweather and a “Human Piranha” whose mouth never seemed to change shape but “expanded and contracted proportionally when he spoke.” In Flash Boys, it is the revelations and not the characters that make the story. The book focuses on Brad Katsuyama, an all-around nice guy who worked as an equity trader at the Royal Bank of Canada (RBC). His job was implementing large stock transactions for institutional clients. Usually, this required breaking a trade into smaller pieces and finding counterparties for each. The trick was hiding his intentions—the size and direction of the overall transaction—so as to not move the market against himself.
In 2007, Brad encountered a problem. Until then, if his trading screens showed 10,000 shares of, say, Intel offered at $22, that meant Brad could buy 10,000 shares at $22. He pushed a button and the trade was done. Now, he pushed the button and the shares available at $22 vanished. This wasn’t a one-time fluke. The same thing happened to him, over and over.
Brad was being front-run by high-frequency traders who would detect his order hitting one exchange and race him to the other exchanges and dark pools, buying the available shares before he could. It all happened in milliseconds, and the high-frequency traders had the technological advantage to always win the race.
Brad didn’t know what was happening. All he knew was that he had a problem. He obtained permission from his employer to run some experiments. Gradually, he conducted tests and assembled a team to reverse engineer what high-frequency traders were up to. The team learned plenty. They created software called Thor to allow clients to avoid tipping off high-frequency traders to their intentions. In January 2012, Brad and much of his team left the Royal Bank of Canada to form a new stock exchange structured to prevent exploitation by high-frequency traders. Called the Investors’ Exchange (IEX), it went live on October 25, 2013.
Brad’s sojourn is just one of several threads running through Flash Boys. We also follow Dan Spivey as he builds a high speed fiber-optic line from Chicago to New Jersey. He doesn’t know exactly how high-frequency traders will use it, but he knows they will pay him millions for the opportunity—and they do. We also follow the poignant story of Sergey Aleynikov, who went to prison for allegedly stealing high-frequency trading code from Goldman Sachs.
Michael Lewis has written several successful books. Until now, none have rivaled his first. Flash Boys won’t be the classic that Liar’s Poker is, but its immediate impact will likely be enormous. Liar’s Poker told a riveting story of Wall Street excess, but it did so mostly after the fact. Flash Boys tells a startling story of abuse—as it is happening in the markets around us.